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1. How Market Sentiment Drives Forecasts of Stock Returns

Author:
Roman Frydman, Nicholas Mangee, and Josh Stillwagon
Publication Date:
05-2020
Content Type:
Working Paper
Institution:
Institute for New Economic Thinking (INET)
Abstract:
We reveal a novel channel through which market participants’ sentiment influences how they forecast stock returns: their optimism (pessimism) affects the weights they assign to fundamentals. Our analysis yields four main findings. First, if good (bad) “news” about dividends and interest rates coincides with participants’ optimism (pessimism), the news about these fundamentals has a significant effect on participants’ forecasts of future returns and has the expected signs (positive for dividends and negative for interest rates). Second, in models without interactions, or when market sentiment is neutral or conflicts with news about dividends and/or interest rates, this news often does not have a significant effect on ex ante or ex post returns. Third, market sentiment is largely unrelated to the state of economic activity, indicating that it is driven by non-fundamental considerations. Moreover, market sentiment influences stock returns highly irregularly, in terms of both timing and magnitude. This finding supports recent theoretical approaches recognizing that economists and market participants alike face Knightian uncertainty about the correct model driving stock returns.
Topic:
Economics, Markets, and Stock Markets
Political Geography:
United States

2. The Knightian Uncertainty Hypothesis: Unforeseeable Change and Muth’s Consistency Constraint in Modeling Aggregate Outcomes

Author:
Roman Frydman, Søren Johansen, Anders Rahbek, and Morten Tabor
Publication Date:
03-2019
Content Type:
Working Paper
Institution:
Institute for New Economic Thinking (INET)
Abstract:
This paper introduces the Knightian Uncertainty Hypothesis (KUH), a new approach to macroeconomics and finance theory. KUH rests on a novel mathematical framework that characterizes both measurable and Knightian uncertainty about economic outcomes. Relying on this framework and John Muth’s pathbreaking hypothesis, KUH represents participants’ forecasts to be consistent with both uncertainties. KUH thus enables models of aggregate outcomes that 1) are premised on market participants’ rationality, and 2) yet accord a role to both fundamental and psychological (and other non-fundamental) factors in driving outcomes. The paper also suggests how a KUH model’s quantitative predictions can be confronted with time-series data.
Topic:
Economics, Markets, Economic Theory, Macroeconomics, and Mathematics
Political Geography:
United States

3. How Market Sentiment Drives Forecasts of Stock Returns

Author:
Roman Frydman, Nicholas Mangee, and Josh Stillwagon
Publication Date:
04-2019
Content Type:
Working Paper
Institution:
Institute for New Economic Thinking (INET)
Abstract:
We reveal a novel channel through which market participants’ sentiment influences how they forecast stock returns: their optimism (pessimism) affects the weights they assign to fundamentals. Our analysis yields four main findings. First, if good (bad) “news” about dividends and interest rates coincides with participants’ optimism (pessimism), the news about these fundamentals has a significant effect on participants’ forecasts of future returns and has the expected signs (positive for dividends and negative for interest rates). Second, in models without interactions, or when market sentiment is neutral or conflicts with news about dividends and/or interest rates, this news often does not have a significant effect on ex ante or ex post returns. Third, market sentiment is largely unrelated to the state of economic activity, indicating that it is driven by non-fundamental considerations. Moreover, market sentiment influences stock returns highly irregularly, in terms of both timing and magnitude. This finding supports recent theoretical approaches recognizing that economists and market participants alike face Knightian uncertainty about the correct model driving stock returns.
Topic:
Economics, Markets, Financial Markets, Econometrics, and Stock Markets
Political Geography:
United States

4. Stock-Market Expectations: Econometric Evidence that both REH and Behavioral Insights Matter

Author:
Roman Frydman and Josh Stillwagon
Publication Date:
06-2016
Content Type:
Working Paper
Institution:
Institute for New Economic Thinking (INET)
Abstract:
Behavioral finance views stock-market investors’ expectations as largely unrelated to fundamental factors. Relying on survey data, this paper presents econometric evidence that fundamentals are a major driver of investors’ expectations. Although expectations are also in part extrapolative, this effect is transient. The paper’s approach underscores the central importance of opening models to structural change and imposing discipline on econometric analysis through specification testing. Our findings support the novel hypothesis that rational market participants, faced with unforeseeable change, base their forecasts on both fundamentals - the focus of the REH approach - and the psychological and technical considerations underlying behavioral finance.
Topic:
Markets, Economic Theory, Survey, and Stock Markets
Political Geography:
Global Focus